Currently, conventional credit derivative markets include a user base of larger institutions. These large institutions use the credit derivative markets for a variety of reasons. For example, commercial banks, both domestic and foreign, can obtain significant economic, regulatory, and capital relief from selling credit risk in a credit derivative market. Commercial banks can also use the credit derivative markets to add credit risk to their portfolios as an alternative to the lending market. Insurers, which typically posses excellent credit evaluation skills, primarily use the credit derivative markets to take on credit risk for a premium. Investment management companies and Hedge Funds, or other investors, use the credit derivative markets to both take on and shed risk.
The dealer community represents some of the largest financial intermediaries in the world. The dealers tend to be large, multi-national institutions that make markets in credit derivatives. The scale and scope of each dealer's credit derivative business varies widely, with some dealers having extensive credit derivative operations, and other being occasional market participants. Thus, in conventional credit derivative markets, information flow is concentrated in a few dealers. Generally, the end users, such as those described above, transact through the dealers and not directly with each other. Often, information is scarce and incomplete as it relates to the buyers and dealers participating in the market, as is information concerning price and the risk associated with particular derivatives.
Dealers transact with other dealers via a broker market. A broker is an intermediary that transacts business between dealers. The brokers do not principal risk. Generally, information dissemination from the brokers is very inefficient. Further, the brokers business is limited to the dealers, because there is no meaningful contact between the brokers and end users.
The flow of information is even more important when a credit event occurs. A credit event is typically an event defined within the credit derivatives contract, that happens in respect to the reference entity. It is usually defined in the Master Agreement of a credit derivatives contract. The three credit events of the reference entity that are defined by the International Swaps and Derivatives Association (ISDA 2003), include Bankruptcy, Failure to Pay, and Restructuring.
Following a credit event, the value of the credit derivatives can fluctuate widely. This occurs because the market standard form of settlement is “physical settlement” which requires that protection buyers deliver bonds to protection sellers to fulfill their contractual obligations. Since credit derivative contracts are synthetic and can be created irrespective of the number of bonds outstanding, the number of credit derivative contracts for a particular company often far outnumber the bonds issued by that company. This results in a “squeeze” artificially inflating the price of the bond due to the high demand. Accordingly, a need exists for a method to determine cash settlement prices for credit derivative trades following a credit event, such as a corporate bankruptcy. Cash settlement eliminates the need for protection buyers to deliver bonds and allows for efficient settlement of credit derivative contracts following a credit event.